I ended the last post saying “that the way I (and I think we) think of housing is better described as a hedge than as a punt. The price of the hedge is still important, but the goal for many is to be hedged so that they can stop worrying about their massive and unhedged liability.” What did I mean?
Well, if you don’t own a property and wouldn’t qualify for social housing, renting is a large, volatile and unavoidable expense. And owning your own home is a means to (almost) perfectly hedge the large, volatile and unavoidable expense of renting. If housing is a hedge and you own less housing than you will ultimately expect to be consuming (eg, you have a one-bed flat and are planning a large family) then you are basically short, rather than long, property. As the Bank said back in 2006 ‘when house prices rise, typically rents do too — so renters face higher housing costs’. So, if I live in an up and coming area, my rent will rise faster than average. We can’t stop and get off the UK housing market just because we’re not enjoying the ride.
But after the last post (about which Katie was characteristically kind) Tom Bowker posed a killer question:
Why is this a killer question? Two reasons.
- It is pertinent. As Tom suggests, it looks like I studiously avoided discussing any framework that might be used to work out whether it is a cheap or expensive hedge in my previous post on house prices.
- It is relevant beyond housing. It is a question that has been occupying almost every UK boardroom in the land. Not that they are obsessing on the price of housing as a hedge, but rather because they have been struggling on the price of hedging their defined benefit pension liabilities. And Tom’s question is about houses as hedges. As I suggested in the last blog, the London property market “make(s) me feel a bit like a de-risking defined benefit pension scheme”.
If we get are allowed to get a little geeky, the analogy of defined benefit pension schemes is not as tenuous as it might sound:
- Pension scheme sponsors are short a stream of long-dated future debt-like cash-flows that will vary in line with the product of inflation, demographic factors and an idiosyncratic factor related to their scheme membership. There is a structural shortage of hedging instruments (long-dated inflation-linked bonds) given lack of supply and foreign demand.
- Renters are short a stream of long-dated future debt-like cash-flows that will vary in line with the product of aggregate rental inflation, demographic factors, and an idiosyncratic factor related to the property in which they live. There is a structural shortage of hedging instruments (houses) given lack of supply and foreign demand.
As such, both renters and pension scheme sponsors are at risk of fluctuations in some combination of long-term real interest rates, a form of inflation, some demographic considerations, and some idiosyncratic factors. And their ability to hedge appears frustrated by structural supply-demand imbalances. Furthermore, it turns out that the way in which UK boardrooms monitor the price of their pension hedge can be used to monitor the price of housing as a hedge.
Long-dated inflation-linked, conventional Gilt yields plus a mix of high-yield and investment grade credit spreads vs UK residential rental yields*
Pension schemes has had their regulatory incentives changed meaningfully over the past couple of decades and this has prompted a good deal of hedging. How can we monitor the changing price of the hedge to defined benefit pension scheme sponsors? I would suggest a combination of long-dated inflation-linked yields, long-dated conventional gilt yields and some combination of investment grade and high yield credit spreads (to account for a rough measure of inflation risk, long-dated real rate risk, and market risk premia that might be employed by schemes to match liabilities). And how can we monitor the changing price of the hedge to renters? I would suggest the residential rental yield. Both are shown in the chart above. It don’t think that it is unreasonable to suggest that attempts by pensions to hedge their liabilities have impacted the price of the hedge available to renters.
I believe that hedging activity in the pensions world has changed the economics of hedging in the housing world. Because pension funds have increasingly wanted to hedge their (plain vanilla) inflation risk (but there has been insufficient supply of hedging instruments), the cost of hedging inflation has become very expensive. This manifests in suppressed long-dated real yields (boosting the price of long-dated inflation-linked bond prices), and has contributed to a rise in price of other forms of inflation hedging (like housing). I should be clear at this point that connecting pension hedging to house prices is (today) a minority position. What is the upshot of this minority view? Well, although housing looks (to me) overvalued as a punt given my expectation of a rise in debt-service ratios over the next couple of years (eg it is a hedge that fewer people will be able to afford if rates rise, dampening demand), it doesn’t look like the most expensive hedge out there given changes in cost of other forms of inflation hedging (for those with the means to hedge). And there’s the tax incentive too (eg, as an owner you pay yourself rent out of your gross income, as a renter you pay someone else rent out of your net income). Which is not insubstantial.
* The residential rental yield is pulled together by taking the product of the average Nationwide house price in 2012 and Countrywide’s rental survey yield for 2012 as an anchor, and then the projecting this average rental forwards and backwards in time using the rental subcomponent of the RPI. This was then divided by the Nationwide house price time series to create a rental yield. It is massively imperfect and I’d be delighted if someone wanted to send me a better time series. The rental yield looks quite high to me, but this (I suspect) is because I live in London. In London the tax incentive to buy will be stronger given higher marginal tax rates associated with higher incomes. And it is also the market in which some folk look to hedge their domestic political risk (eg wealthy foreigners living in unstable regimes seeking a bolt-hole where the rule of law is strong).